Sources of Funding for a small business

Updated: Feb 25, 2020

Introduction

In this article we explore the raising of funds to help you support business growth. We will look at working capital, loans, grants and equity funding separately as they all have a role to play in helping to fund your businesses growth.





1 Working Capital

Working capital is the money the business generates from profit – over time this can build to become a source of funds for further investment. This may mean taking a lower salary initially, or deferring the rental of office space. Whatever you can do to increase sales or reduce costs will lead to an increase in working capital and allow cost free funding for the business.

However, where there is a shortage of working capital, for example where you need to pay suppliers in advance of receiving payment for invoices issued, other sources of funding will need to be found.


2 Loans

When you borrow money via a loan to fund your business - either in the start up stage or if you need an injection of money to cover late payments, etc – there are some basics you should be aware of.

Some of the common terms and factors to consider:

A loan will consist of capital and interest. Capital is the amount you are borrowing, and interest is the amount you will pay in addition to the capital, ie the cost of the loan. The interest on a business loan is a tax deductible expense.

Each payment you make will be a mix of interest and repayment of the capital – over the time you make payments (the term of the loan) the amount of capital you owe reduces.

The loan will either be secured or unsecured.

Secured means that the loan is secured against another asset, such as a home or business stock, or by another person. If the business fails to make the repayments on the loan the lender can take the asset used as security or expect the other person to repay the loan. How this works in practice would be set out in a loan agreement.

An unsecured loan is one that has no backing, so that if the loan is not repaid by the business the lender cannot make a claim on other assets of the business. Due to the higher risk an unsecured loan is likely to have a higher interest rate.


2.1 Savings

If you have savings you should consider using them before securing funds from elsewhere. The rate of interest you can otherwise earn on savings would not outweigh the cost of other sources of funds. For example if you earn 1.5% on your savings this would currently be far less than you pay as interest on loans.

Your personal savings would be a loan you make to your company and would repayable to you without any tax implications, however it's more complicated if you charge interest on the loan.

However if you want to retain a pot of money for a rainy day and have a limited company structure, in effect separating yourself from the company’s liabilities, it can make sense to secure funds elsewhere and keep the savings as a backup in case of difficult times.


2.2 Friends/Family

A loan from family of friends will be simple to put in place (but always have an agreement with standard terms defined in case of problems later on, and for tax reasons – you can find templates of these online).

It should be quick to get the funding with no form filling and proof of income required and possibly at lower interest rates than other sources. This funding is likely to be unsecured dependent on how much money your friends/family have to spare/risk.

However, it is worth considering the impact on the relationship if you were unable to repay the loan – make sure the loan agreement specifies what happens if loan repayments are missed or the business runs into cash flows problems or fails completely.

There may be a tendency for the lender to want to have a say in the running of the business – make sure their role (if any) is well understood or maybe documented in the loan agreement.


2.3 Government loan

For start ups, defined as companies that are in planning stage or have been fully trading for less than 2 years, consider the following unsecured loan with an interest rate of 6% - https://www.gov.uk/apply-start-up-loan - loans are from £500 to £25,000 and there is also a business mentor available for 12 months



2.4 Bank loan

Bank loans can be quick to secure – and the longer you have been with the bank the easier it will be to secure funds. The interest rates vary so look around for the best rates. These can be unsecured or secured.

Usually the business will need to have shown some months/years of trading to secure a loan, so these will not always be the best option for start up companies.


2.5 Overdrafts

If you already have a relationship with the bank, maybe as a personal banking customer, you may be able to secure an overdraft quickly. An overdraft should always be arranged (agreed with the bank) as unarranged overdrafts (where you did not agree an amount with the bank in advance) are very expensive – however, arranged overdrafts have recently also become expensive also and need to be considered very carefully.

Overdrafts can be expensive compared to other sources of funding. If you have a tendency to rely on an overdraft – it would be better to have a separate arrangement and to repay the capital element over time (a lower interest rate would allow faster repayment of the capital).


2.6 Invoice Financing

This is a relatively expensive form of funding – where you ‘sell’ the future receipts that have been invoiced and receive the funds in advance (less the lenders interest/fee). When the customer pays you, say a month later, the amount received is transferred to the lender.


2.7 Asset Finance

This is to finance a particular piece of equipment to use in the business, for example a commercial oven or printing machine. You won't own the asset until all repayments have been made. This can be a useful form of finance where large and expensive pieces of equipment are required before you can start the business, or if you need to update older equipment.


2.8 Crowd Funding – Peer to Peer lending

This form of funding has been popular in recent years and is where a number of individuals will fund a business directly via a crowd funding platform. These offer the investor a better rate of return than with other savings, but at an increased risk of loss. Hence this tends to be a more expensive way of borrowing money, but one in which like-minded individuals are involved. There are several crowd funding platforms so read online reviews before engaging with the one that best fits your business type.


3 Grants

There are many grants available in the UK for small and rural based businesses. The application process tends to be more onerous than with other forms of funding. This is because grants are not loans and so do not need to be repaid. They exist to promote certain social benefits, for example urban regeneration. They can be a valuable resource either for initial funding of a business of for further development for an established company. To search for available grants use a site such as: https://www.grantsonline.org.uk/about.html



4 Equity funding

If you offer a share in your company in return for money you will not be charged interest and will not be expected to pay back the loan – instead, if your company is successful and becomes more valuable, the investor will have a share (also known as equity) that they can sell onto others. This is the principle in Dragons Den. Each dragon is offering money in return for a share of the company. Sometimes you will hear the entrepreneur asked for a reduced equity stake for the investor if they repay some of the capital. This is a mixed approach, but still no interest is payable on the funds invested.


4.1 EIS/SEIS/Social Enterprise Share Schemes

There are 4 schemes offered to investors by the government designed to help small or medium sized companies and social enterprises grow by attracting investment. They offer tax reliefs to individuals who buy and hold new shares, bonds or assets for a specific period of time. See more here: https://www.gov.uk/guidance/venture-capital-schemes-raise-money-by-offering-tax-reliefs-to-investors


4.2 Angel Investors

Angel investors are private individuals or groups of individuals that will provide funds in return for a share in the company. This will usually be of interest once the company is established and is needing funds to allow further development. Such funds can be via the above mentioned government schemes or separately funded. Angel investors will sometimes want to be involved and steer the company's direction.